When leasing commercial space, it's important to thoroughly evaluate the impact of each of the lease's terms before signing a commercial lease.
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After all, two of the major cash flow components of small business operations are the start-up capital requirements for buying or renting commercial real estate and the ongoing expense of operating the space in which the business is located.
This article deals with some of the ownership value considerations of real estate. We explore some of the important areas for small business owners to consider when leasing their business location. This information also can be used in preparing a checklist to compare alternative sites if your company is expanding or relocating.
The first basic concept to understand about real estate lease is whether it is considered a "net" lease or a "gross" lease.
There is a considerable confusion about the proper terminology. Some people refer to terms such as "triple net", "modified gross", "gross plus utilities," "net, net," or even "net, net, net." The reality, however, is that a lease is either "net" or "gross," and that all other terms are simply derivations from the theme.
The second basic concept is that if a lease is net, this means that you, the tenant (the lessee), will be responsible for at least one additional expense of the space over and above the base rent. A gross lease means that all applicable cost over the base rent that are associated with the space are included in the total rent, and are the responsibility of the landlord (the lessor). In today's real estate market, a true gross lease is rare, because most tenants pay at least one or two expenses associated with their business location.
Another term that is particularly important to some retail merchants and restaurants is the concept of "percentage rent." This means that all or part of the rent is calculated based on a predetermined formula using the sales revenue generated at that location. For example, the rent may be calculated at $5 per square foot, plus 1 percent of sales over $1 million.
One theory behind this concept is that the rental value of the space is directly linked to the strength of the location of your store or the shopping center in which you are located. In this case, it is important for the parties to agree on the definition of sales revenue and what is included or excluded from the definition. There are two schools of thought on this concept. The first says that it is no one's business but your own regarding how much sales revenue is generated by your business. The other faction feels that if a location is strong enough to generate additional customer traffic and sales volume, then the percentage rental factor is a justified cost of doing business and is worth the extra cost.
There are numerous legal terms in lease agreements, and some leases are quite intimidating to the small business owner who may be unfamiliar with the business of leasing real estate. Quite often, the landlords and brokers representing their properties are career professionals in leasing, and small business owners are at a distinct disadvantage in negotiations. It is always advisable to secure the services of a competent attorney knowledgeable in real estate matters.
In some circumstances, it also may be beneficial to secure the services of a real estate broker who is knowledgeable in tenant representation. In this scenario, a broker works for you, the tenant, as opposed to a conventional brokerage fees might be actually paid through the landlord's commission to the broker(s) involved, which will help the business owner's cash flow.
In lease negotiations, it is important to remember that every single item in a lease is negotiable, and may have real perceived economic value to you or the landlord. What this means is that negotiated terms of lease may be translated into actual costs or savings to either party. Certain terms critical to you may be less so to a landlord and vice versa. For example, having designated parking for your employees may be important to you, resulting in cost savings for them, but parking costs may not be as important an issue to the landlord.
The terms below represent some other general area to consider when comparing competitive locations:
- Common area factor: This is a term that defines commonly shared, public space within buildings (usually office buildings). This can include hallways, vestibules, rest rooms, lobbies and atriums. The factor is usually described as a percentage and should be accounted for in your space allocation. For example, you may be using 1,500 usable square feet, but if the common area factor is 15 percent, then your rentable square feet is 1,725 square feet. Other buildings may be different, so be careful when comparing your effective rental rate.
- Common area maintenance: The cost of maintaining the exterior and/or the shared interior areas of a property may be passed through form the landlord to a tenant. These costs may include snowplowing, rubbish removal, parking lot lighting, cleaning of restrooms. Property management, taxes and other costs. It is important to identify the amount of these costs, which is included in the rent (also known as "stops") which may increase or decrease over time.
- Escalations, graduations, indexes and adjustments: These terms will define other methods to be used to change the rent over time. They may take the form of absolute dollar changes (e.g., $100 per month), defined percentage changes (+5 percent), unknown future percentage changes (CPI, or consumer price index) and other mutually acceptable measures.
There are many other lease terms that can affect your legal rights as a tenant. As a small business owner, it is important to evaluate the impact of each of the lease's terms to you and your business, their potential value and/or their possible hidden costs which will affect your overall effective rental rate.
Article reprinted with permission from the NH SBDC. This article was written by Gary N. Chabot.
© 2002 NH SBDC